Speeches

The Recovery - Has It Begun?

Good morning. It is a pleasure
to be here. The economic outlook for 2002 is an issue on
everyone's mind. As I talk to people in our area about the
state of the economy, I hear a bit more optimism these days,
but also some lingering apprehension. I think both sentiments
are well founded. This morning, I will offer you my own
perspective on where we are and what lies ahead for the
nation and for our region. Then, I will open the floor to
your questions.

Let
me begin by answering today's topic question directly. Has
the recovery begun? My answer is that the recovery may indeed
have begun. Recent statistics on economic activity are heartening,
in fact, surprisingly strong. However, the balanced growth
of a true recovery requires improvement in a broad range
of economic data, such as employment, manufacturing activity,
and consumer and business balance sheets. The data show
some evidence of this, but more will be necessary before
a true recovery can be assured.

That
said, the stage has been set; I expect to see solid evidence
of a recovery underway over the next few months. Compared
to past recoveries, this one may turn out to be somewhat
milder, at least in its early stages, in light of the way
the recession has evolved. Nonetheless, I expect the recovery
to deliver a healthy rate of economic growth by mid-year,
and into the year's end.

Perspective
on Recent Experience

The
economy officially slipped into recession just a year ago,
in March 2001, according to the National Bureau of Economic
Research, the organization that dates business cycles; though
for most of us, this recession will always be associated
with the events of September 11. Economic activity declined
in the third quarter of 2001, after a significant slowdown
in growth earlier in the year. This was a period of great
uncertainty and significant employment decline; the economy
lost nearly one million jobs in the fourth quarter of 2001
alone. Yet, there were also some positive developments by
year-end 2001 that helped set the stage for recovery in
2002.

On
the policy front, both monetary and fiscal policymakers
responded quickly and significantly to help counteract the
negative economic effects of September 11. The Fed cut both
the federal funds and discount rates by a full percentage
point in two moves immediately following the attacks. Congress
and the President authorized expenditures to help with rescue
and rebuilding, support affected industries, improve security,
and mount a military response. This led government spending
to increase at a 10 percent annual rate in the fourth quarter
- its biggest quarterly gain in over 15 years.

Both
the monetary and fiscal policy actions were additions to
stimulative policy steps taken earlier in the year. The
Fed began cutting short-term interest rates back in January
2001 when economic activity showed a sharp drop-off. Congress
and the President had implemented a 10-year tax reduction
program and kicked it off with cash rebates to individual
taxpayers last summer.

The
net result is that we entered the year 2002 with considerable
policy stimulus at work in the economy. The federal funds
rate stands at just 1-3/4 percent, some 475 basis points
lower than one year earlier, and at its lowest level since
1961. In addition, fiscal policy remains a powerful stimulus
to the economy, as represented by the swing in the federal
budget from a surplus of $236 billion in fiscal 2000 to
a projected deficit of $106 billion in fiscal 2002.

By late
2001, these earlier policy actions were working to temper
the downturn. Though employment fell in the fourth quarter,
economic activity expanded. Last week's GDP report showed
that the increase in economic activity was the result of
increased consumer spending, fueled in large measure by
low interest rates --- including zero-percent financing
on autos, which automakers were able to offer because of
low interest rates overall --- and the sharp increase in
government spending.

The
full impact of the monetary and fiscal policy stimulus has
yet to be felt. Our monetary policy actions have their maximum
effect on economic activity nine months to a year after
we take them. So the interest rate cuts we put in place
in 2001 will help stimulate the economy well into 2002.
On the fiscal policy side, additional stimulus is already
programmed in for 2002, as the result of increases in defense
and security expenditures and a continuation of the 10-year
tax plan.

Interpreting
the Present Economic Situation

As
we gather here at the end of the first quarter of 2002,
the good news is that the stimulus seems to be working -
indeed, perhaps even better than we had anticipated. Consumer
spending continues to increase. Retail sales have shown
strong growth thus far in the cycle.

Just
as important, spending increases are now beginning to generate
increases in production. This is welcomed. Businesses cut
inventories aggressively throughout 2001. As soon as demand
began to soften, they cut production sharply to stave off
excess inventory accumulation. As demand for their products
decelerated, they continued to cut production, meeting demand
with product already on the shelves and further trimming
inventories. These actions amplified the impact of the downturn
in demand on the manufacturing sector, and industrial production
fell sharply.

Now,
we are seeing the first signs that aggressive inventory
cutting is coming to an end, and as demand expands, production
is beginning to pick up. Our Bank's Business
Outlook Survey was the first indicator to show signs
of a turnaround. The survey polls manufacturers in the Third
District every month  some of you here may be participants.
In January, the survey registered its first positive reading
since November 2000, and it moved slightly more positive
in February. Now other manufacturing surveys, including
the National Institute for Supply Managers' survey, are
picking up as well.

Likewise,
labor market conditions are starting to firm. The first
employment report for this year showed that while the economy
lost jobs in January, the rate of decline continues to slow.
We all await the employment report for February, which will
be released this Friday, for further evidence of the slowdown
in job losses. It is important that employment begin to
increase and employment prospects to brighten in order to
sustain the growth in consumer spending that we have been
observing.

Meanwhile,
sales of homes and automobiles remain remarkably robust.
As you know, the market for residential real estate has
proven surprisingly resilient in the face of the economic
downturn thus far. And while auto sales have moderated from
the record-setting pace of late last year, the financing
deals that generated that sales surge seem to have robbed
surprisingly few sales from this year.

Looking
Ahead

With
things going so well, one might be tempted to project a
robust recovery for the economy in 2002. But a more moderately
paced recovery is the more likely scenario. Growth in consumer
spending and the sales of new homes and cars are likely
to remain solid, but they are not likely to surge from their
already high levels in the months ahead. And the outlook
for the other important component of spending, business
spending, is less optimistic. Inventories are likely to
be restocked slowly, and business fixed investment is likely
to recover at only a modest pace.

There
are a number of factors limiting the growth in consumer
spending. Perhaps the most obvious is the lack of pent-up
demand. Normally, when the economy weakens, consumers, concerned
about their employment prospects, postpone their purchases
of big-ticket items. Then, once they see signs the economy
is improving, they go out and buy the new car, the new home,
or the major appliance that they wanted. In this cycle,
consumers have continued to spend through the downturn,
apparently postponing few purchases. As the economy improves,
they will be less motivated to go on a spending spree.

In
fact, when consumers consider their financial position,
they may find reason to watch their spending. Consumers
have accumulated considerable debt over the past several
years, and the ratio of their debt service payments to their
disposable income is close to a record high, in spite of
lower interest rates. This is occurring at a time when the
value of their stock portfolios has declined significantly
and is subject to considerable uncertainty going forward.
So, while consumer spending may increase at a solid pace
over the coming months, it will likely not be the driver
of rapidly accelerating growth.

As
we move out of recession, interest rate reductions and price
cuts will recede as spending motivators, but they should
be replaced by better income and employment prospects. At
the same time, sales of homes and autos will remain at the
relatively high levels they have achieved in recent years,
but their rate of growth is unlikely to accelerate markedly.

Business
spending, both inventory rebuilding and capital expenditure,
is more of a concern for the near-term outlook.

We
should keep in mind that businesses cut inventory adjustment
not only by cutting production but also by cutting prices.
In fact, price declines in the fourth quarter left little
room for profit and even less enthusiasm for rapid inventory
rebuilding. Accordingly, I sense a rather cautious business
sector, and I expect firms to replace their depleted inventories
more slowly than usual. Of course, simply ending the inventory
decumulation would boost near-term growth but would do nothing
to sustain it over the longer term.

Then
there is the prognosis for business fixed investment. One
must recall that it was the collapse in business investment
spending that pushed us into the current recession. The
double-digit growth in investment spending that powered
the expansion in the late 1990s gave way to double-digit
rates of decline in 2001.

Business
investment will have to turn around and begin growing again
if we are to sustain the recovery and achieve a healthy
pace of growth. My own expectation is that a strong turnaround
in business investment spending is several months away.
It will occur once the recovery gets fully underway and
rising capacity utilization and better corporate financials
enable firms to begin investing again. I expect the growth
in investment, however, to be more moderate than it was
in the late 1990s.

At
that time, of course, businesses were ramping up their investments
in high-tech systems. Businesses saw these developments
as an opportunity to expand capacity, increase efficiency,
and experiment with whole new business models. They were
also preparing for Y2K. When the tech bubble burst and the
economy began to soften, the shakeout began and investment
spending began to plummet.

Declining
capacity utilization and the slump in corporate profits
reinforced the downward spiral. These factors will unwind
only gradually.

Typically
the industrial sector operates at something over 80 percent
of capacity. Presently, it is operating at just over 70
percent. As production picks up and the capacity utilization
rate rises, firms will have greater incentive to expand
operations and increase capacity.

The
other substantive drag on corporate investment is the slump
in corporate profits and the weaknesses in their financial
position. Banks are reporting increases in delinquencies
and chargeoffs on their commercial and industrial loans.
From the banking perspective, the problems are well contained.
Banks are well capitalized and have adequate loan loss reserves.
Nonetheless, increased delinquencies and chargeoffs point
to underlying softness in the business sector and the caution
to which I just alluded. Again, as the recovery unfolds,
businesses' profitability and financial position should
improve, clearing the way to increase investment spending,
but, at least for now, they pose some downside risk.

Longer
term, prospects for steady growth in business investment
spending are good. The fundamental drivers of strong investment
spending  the competitive pressure to increase productivity
and the availability of more powerful technology at lower
prices  are still at work.

Steady
growth in business investment spending is important not
only for its contribution to the growth in overall demand
for goods and services but for its contribution to the economy's
capacity to supply those goods and services. Strong investment
spending boosted productivity growth in the late 1990s,
and productivity growth has held up relatively well thus
far in the downturn. The consensus is that continued diffusion
of new technologies through the economy will keep labor
productivity growing at an annual rate of 2 to 3 percent
on a sustained basis. With our labor force itself growing
at about 1 percent per year, the economy has the capacity
to grow at 3 to 4 percent. I subscribe to that view.

Indeed,
if the recovery unfolds as I expect, then the economy will
be growing at a steady 3 to 4 percent rate in the second
half of this year. Acceleration to growth in this range
should generate enough new jobs to cap the unemployment
rate at about 6 percent by the second half of this year
and begin bringing it down. At the same time, the moderate
pace of growth should prevent the accumulation of any inflationary
pressures.

I
should add that my prognosis for economic recovery in the
U.S. is predicated on continued growth and stability in
the global economy. The dollar has been remarkably stable,
and I do not anticipate any substantive change in the market
for our exports. But shifts in economic conditions among
our trade partners or developments in international financial
markets could affect the path of our recovery. Likewise,
oil prices have settled down and the war on terrorism seems
to be under control, but a dramatic change on either front
would have a significant impact on the outlook.

So,
Where Does This Leave Us?

Barring
such developments, I am cautiously optimistic about the
U.S. economy in 2002. The balanced growth of a true economic
recovery should soon be underway. The recent strength in
consumer and government spending should lead to growth in
business expenditures and in overall production, as we move
through 2002. A more rapidly expanding U.S. economy will
help support a stronger global economy, and that, too, will
reinforce growth here.

However,
risks remain. We want to be confident that the recovery
is sustainable and built on a strong foundation. To assure
this, all forces necessary for a balanced recovery must
align. This should occur over the next quarter or so.

As we
see evidence that the recovery has taken hold and is building
momentum, risks will become more balanced. Monetary policy
must then shift gears, moving from its current stance, geared
to stimulating a recovery, to a more neutral stance, geared
to sustaining a long-term expansion.

Some
Thoughts on the Region

In
my remaining time with you I would like to turn the spotlight
on our local economy. How will our region fare in the year
ahead? Let me say that I expect Greater Philadelphia and
the Main Line community to be full participants in the national
recovery and expansion that I foresee this year.

This
has not always been the case. As I noted at last year's
Chamber meeting, the past few economic downturns have hit
our region harder than the nation as a whole. We tended
to slide into recession sooner, decline more sharply, and
recover later than the rest of the country. The city of
Philadelphia usually bore the brunt of the past slowdowns,
but the entire region was also affected. At that time, I
noted that I hoped, indeed expected, that this would be
changing as a result of the shift in the composition of
economic activity located in the Delaware Valley.

Recent
evidence seems to support this assertion. Greater Philadelphia
is running on an even keel with the national economy. Employment
fell here only when the nation's did, and our unemployment
rate is currently below the national average.

Of
course, other cyclical developments in the national economy
have also been reflected here in the local area. The residential
real estate market has been strong, and home builders have
been extremely busy. The weakness in the business sector
has shown through as softening demand for office space and
spotty demand for commercial and industrial space. The good
news is that as the region continues to move in sync with
the nation, the national recovery should also bring a turnaround
in these segments of the regional economy as well.

No doubt,
the closer alignment of our region's economic performance
with the nation's is a result of our evolution from a manufacturing-based
region to a more service-based economy. In addition, our
region's concentration in knowledge industries, primarily
health care, education, biotech, and pharmaceuticals, has
made us less susceptible to unemployment in economic downturns.
Nearly one-third of the Philadelphia metro area's workforce
is now in knowledge occupations, that is, requiring formal
education at the bachelor's degree level or higher.

In
truth, some of our current strength comes from earlier weakness.
The Delaware Valley had a smaller technology-based sector,
and, on this side of the river, telecom was not a major
force. So, as these industries declined, we were not disproportionately
hurt. Going forward our challenge is to build up these areas,
where appropriate, and be sure that we participate in the
new growth that they represent.

It
seems appropriate to raise this issue here on the Main Line,
as this business community has been one of the most successful
in our region. Thanks to the long economic expansion of
the 1990s, the growing 202 Corridor and the opening of the
Blue Route, the number of jobs in Montgomery and Chester
counties jumped 21 and 35 percent, respectively, over the
past 10 years. This growth has been in new and vibrant industries,
knowledge occupations as I have called them before.

In some respects, this is just the latest demonstration
of the power of a transportation network to shape a region's
economy. We can go back to the 1950s with the construction
of the Pennsylvania Turnpike, the Schuylkill Expressway,
and Route 202. Each of these roadways brought high-tech
firms, pharmaceutical companies, retailers, and financial
firms to the surrounding area. I suppose there is some truth
to the axiom, 'If you build it, they will come.' But there
is more to it than that. You offer larger spaces, lower
taxes, and a quality of life that appeals to both new and
relocating firms, as well as their employees.

Conclusion

In
closing, I see 2002 as a turnaround year for the U.S. economy
and for our region. We weathered some significant difficulties
in 2001, and we may yet have some anxious moments in 2002.
Still the year is off to a good start. We should see consistent
signs of renewed growth by mid-year and a healthy pace of
growth through the second half. I am optimistic about the
economy's long-run prospects. With continued strong growth
in productivity, we can sustain a higher rate of real growth
than most of us would have thought possible just a few years
ago.

The
challenge for us at the Fed is to set monetary policy conducive
to achieving and sustaining economic growth at full potential.
The challenge for you, as business leaders, is to continue
to compete, innovate, and seize good opportunities with
confidence, as I am sure you will.